Let's say you purchase $3,000 of Vanguard S&P 500 (the minimum mutual fund purchase price, I believe). To oversimplify, Vanguard takes $3,000 and buys the biggest 500 companies in the stock market with that money. It expands it's S&P 500 fund when you buy shares, and it sells some when you sell some. The entire thing is a giant bag of shares from every company on Standard and Poors (S&P) list of 500 stocks.

But it's more complex in reality, without defying the general outline I mentioned above. Vanguard keeps a small percent of the fund in cash to deal with purchases and sales. It then uses derivatives to simulate that cash as being in the market. Also, it doesn't just hold 500 stocks, it holds about 509 stocks. That way when someone tries to guess what stock will be next added to S&P's list, Vanguard already owns it (when two companies in the S&P 500 have a merger, it leaves an open slot in the S&P 500).

The way ETFs work would probably just scare you more, so I typed that up then deleted it. :) But ETFs also react to demand by purchasing more shares of S&P 500 companies, it's just done by outside institutions reacting to market demand for ETF shares.

Let's say you purchase $3,000 of Vanguard S&P 500 (the minimum mutual fund purchase price, I believe). To oversimplify, Vanguard takes $3,000 and buys the biggest 500 companies in the stock market with that money. It expands it's S&P 500 fund when you buy shares, and it sells some when you sell some. The entire thing is a giant bag of shares from every company on Standard and Poors (S&P) list of 500 stocks.

But it's more complex in reality, without defying the general outline I mentioned above. Vanguard keeps a small percent of the fund in cash to deal with purchases and sales. It then uses derivatives to simulate that cash as being in the market. Also, it doesn't just hold 500 stocks, it holds about 509 stocks. That way when someone tries to guess what stock will be next added to S&P's list, Vanguard already owns it (when two companies in the S&P 500 have a merger, it leaves an open slot in the S&P 500).

Sorry if I'm being dense, but I'm not sure how this answers my question. I understand what comprises a typical index fund but I don't know if the fact that Vanguard is now managing such a huge majority of money invested in index funds makes any difference to me as an individual investor - am I taking on more or less risk, or should I expect anything to change? What if Vanguard managed 100% of all index fund investing, would it make any difference to me?

I guess my assumption is that the optimal risk/value for me is when all companies that manage index funds have an equal share of the market. This makes sense for other types of businesses as far as I know - when one company has a monopoly over a given market, it seems like that is generally bad for customers. Does that not apply to companies that manage index funds?

Another point the article brought up - which I've seen mentioned many times, but never explained - is that Vanguard is owned by its funds, instead of being privately or publicly owned. I don't understand what that means. Do each of the funds actually own a certain number of shares in the parent company? If so, the prospectus doesn't mention it.

What if Vanguard managed 100% of all index fund investing, would it make any difference to me?

If they became a monopoly, then the "risk" is that they would start hiking their management fees. Don't forget that all Vanguard is is a management company. The assets they hold are ordinary stocks and their performance (i.e. the market) is where the risks lie, not with Vanguard.

Another point the article brought up - which I've seen mentioned many times, but never explained - is that Vanguard is owned by its funds, instead of being privately or publicly owned. I don't understand what that means. Do each of the funds actually own a certain number of shares in the parent company? If so, the prospectus doesn't mention it.

If they became a monopoly, then the "risk" is that they would start hiking their management fees.

That second quote is why the first one is important. Most of Vanguard's competitors are owned by shareholders, so if they got a monopoly of index investments, they would likely start charging more for them, to make a profit for their shareholders. Vanguard's shareholders are its funds, and in turn the funds' shareholders are their investors, so if Vanguard gets a monopoly of index investments their incentive remains to be as efficient as possible with the fees they charge.

Operational risk is never zero. But Vangaurd's is as close to zero as you can get. Investing in the individual stocks through direct registration, where you hold the actual stock certificates and get dividend checks mailed to you, might be the only safer thing for now. Might.

It is worth following Vanguard's organizational changes over the long term to make sure it remains that way.

I can't remember where I read it, but I remember reading a recent article that said the markets have been much less volatile in the USA than expected during Trump's term of office so far, because so many investors have switched from active stock picking to passive investing with Vanguard and others. The markets aren't responding as negatively to events as they have in the past, because more investors are simply buying index funds and just letting their money stay put. I thought that was interesting.

That article mentions that Vanguard is "client owned", and "The Vanguard Funds ... are the owners of Vanguard." But it doesn't say what that means.

As an owner of something, I can use it, not use it, give it away, sell it, dispose of it. Basically, I possess it and can control it. As an owner of stock, I can do all that plus vote on leadership and other major issues that come before the shareholders.

But I can't do any of that with Vanguard. I do not have a certificate that says I own part of the company. I do not get a vote on any officers or issues.

Solon, it might help to read up on mutual companies (which is what Vanguard is). Basically if there is a profit, they would pay it out to their funds as a dividend, so that every customer/client who owns shares benefits as though you you owned shares in Vanguard. From what I understand, they just operate so that their funds are sold at cost, and there are no profits. (This is better tax-wise than charging higher fees and then distributing the excess right back to us as taxable dividends.)

To oversimplify, Vanguard takes $3,000 and buys the biggest 500 companies in the stock market with that money.

Sorry if I'm being dense, but I'm not sure how this answers my question. I understand what comprises a typical index fund but I don't know if the fact that Vanguard is now managing such a huge majority of money invested in index funds makes any difference to me as an individual investor - am I taking on more or less risk, or should I expect anything to change? What if Vanguard managed 100% of all index fund investing, would it make any difference to me?

I guess my assumption is that the optimal risk/value for me is when all companies that manage index funds have an equal share of the market. This makes sense for other types of businesses as far as I know - when one company has a monopoly over a given market, it seems like that is generally bad for customers. Does that not apply to companies that manage index funds?

There's about $20 trillion worth of U.S. stocks, and Vanguard manages less than 1/4th of that total - not a majority.

I hoped my earlier comment made the connection for you between your money and where it goes. Vanguard doesn't hold your money in a bank account - it hands it over to a trustee that executes trades. There's a few layers of protection, and the SEC watching over it all... ah, I know what you're missing.

Madoff Securities was NOT a registered investment company. "Regulated Investment Companies" have a separation between managers who decide what to buy, and the people touching the actual money, who execute the trades. Vanguard funds are regulated by the SEC. Read up on that if your mention of Madoff represents the risk that worries you most.

The investing world would still be screwing customers with 1% expense ratios if it could. Vanguard both made the customers into owners of the company, and introduced mutual funds with very low fees. Those low fees attracted customers. The reason Fidelity and Schwab introduced lower fees isn't because they like handing their profits over to you and me - it's because Vanguard was attracting so much business. Other companies felt they couldn't remain competitive with Vanguard while charging too much, and lowered their fees. So yes, competition is a good thing, but right now Vanguard has been fighting this battle for ~40 years and hasn't come out ahead until rather recently.

Madoff Securities was NOT a registered investment company. "Regulated Investment Companies" have a separation between managers who decide what to buy, and the people touching the actual money, who execute the trades.

Not necessarily. SEC registration (the actual term is RIA, registered investment advisor) is mainly just a requirement to file and disclose the identities of the owners and the company's business practices. It has other consequences, such as being subjected to audits.

There are RIAs out there that don't manage or hold a single dime, such as consultants.

That said, part of any good due diligence will be on separation of duties between traders, risk managers, performance analysts and so on.

The article author cites several sources which state that the impact of this lawsuit is likely to be minimal even if Vanguard completely fails, but I find the issue a little interesting given my significant stake in Vanguard mutual funds. Essentially, the argument is that even though Vanguard acts as a mutual fund company, it is technically set up as a C corporation, and tax laws require paying taxes on the fees it could have earned had it charged market rates. As the article mentions, the laws governing this were written and are used mainly in the setting of company subsidiaries, in order to prevent wholesale transfer of profits from one part of the company to another, which could be used to avoid taxes based on geography. Of course that's not what Vanguard is doing, but I guess the Vanguard whistle blower is arguing that the actual wording of the tax laws does not exempt Vanguard from this consideration. So while this is probably not a potential source for the downfall of Vanguard, it is a concrete example of there being possible vulnerabilities.